Process costing is an accounting method typically used by companies that mass produce verysimilar or identical products or units of output. It’s common in manufacturingindustrieswhere the costs of producing each unit of output are very similar, and it doesn’t makesenseto try to track costs for each individual unit throughout the production process. Forexample, process costing is used by oil companies that produce millions of gallons of fueland by processed food companies that make millions of identical packages of snacks.
What Is Process Costing?
With process costing, companies determine item cost by tracking the cost of each stage in theproduction process, instead of tracking costs for each individual item. After adding up thecost of all the steps in the process, they divide the total cost by the number of items.This is called the cost per unit. For example, a paper company might track the cost of eachstage in the process of turning wood pulp into reams of paper, then divide the total cost bythe number of reams to get the cost per ream.
Key Takeaways
- Process costing is an important product costing method for manufacturing companies thatmass produce a large volume of similar products or units of output.
- Process costing is widely used in industries such as oil refining, food production,chemical processing, textiles, glass, cement and paint manufacture.
- When using process costing, companies determine item cost by tracking the cost of eachstage in the production process, then divide the total cost by the number of itemsproduced.
- Companies can calculate costs using several different methods, including weightedaverage costing, standard costing and first in, first out (FIFO) costing.
Process Costing Explained
hom*ogeneous items are products that cannot be distinguished from one another — forexample, abin of screws of the same size and type. These similar products all generally flow through anumber of stages during the production process. To use the process costing approach to accounting, companies determine the direct costs andmanufacturing overhead for each of those stages.
These stages include direct and indirect costs. Direct costs are those directly incurred forproduction, such as raw materials and machine operators’ wages. Overhead oftenincludesindirect costs such as equipment maintenance and facility rent, as well as the wages ofadministrative staff who aren’t directly involved in making the products.
Companies often break down these costs into direct materials and conversion costs. Directmaterials are the materials consumed at each stage; conversion costs are process-relatedcosts such as payroll and manufacturingoverhead.
At many companies, a different department handles each stage in the production process. Eachdepartment prepares a report that details its direct materials, direct labor andmanufacturing overhead costs. The company then aggregates these reports to analyze totalproduct cost.
Process vs. Job Costing
Two of the primary methods of determining the cost of each product are process costing andjob costing. Process costing doesn’t rely on tracing the costs of each individual itemthroughout the production process, so it’s particularly useful for industries thatmassproduce identical items and cannot easily trace each item’s costs. Job costing, incontrast,tracks all direct and indirect costs for each item or project. This is more commonly used bycompanies that offer custom products or services and price each one individually. Forexample, a construction company that makes custom homes needs to know exactly how much itcosts to build each house so it can charge an appropriate amount and track whether eachhome-building project is profitable.
Importance of Process Costing
Process costing is particularly important in the oil, chemical, lumber, textile and foodprocessing industries. Getting a handle on production costs enables these companies to setthe right prices for their products and determine whether costs are tracking in line withprojections. They can use process costing to analyze the costs of each step of theproduction and distribution process and use the information to identify areas where they canreduce costs.
Why Use Process Costing?
Process costing is the logical choice for keeping tabs on product costs in industries wherethe individual units of output are uniform and individually not worth a great deal —such asreams of paper or bottles of soda — and where it’s impossible or difficult totraceproduction costs for each individual unit. Instead, the cost of goodsmanufactured (COGM) isproduced using process costing. This usually appears on your income statement.
Monitor profit margins: For industries that sell in high volume andoperate with narrow profit margins, even a slight change in process costs can make abig difference to a company’s profit. Process costing enables companies tohome inon the cost of each production stage and target specific departments forimprovement.
Inventory control: Depending on the type of business, you may berequired to report inventory to the IRS for tax purposes. For large companiesproducing thousands or even millions of products, this can be a difficult task.However, process costing can help simplify it. Each item produced is valued and eachdepartment tracks things like materials purchased.
Uniformity in reporting: With process costing, each department willtrack their own costs and all those will be rolled up to arrive at an overall costto produce a specific number of items. Because all expenses have to be addedtogether, they all need to be reported in the same manner and with the same costcodes. This helps bring uniformity to reports and makes it easier to track costsover time.
Using the Process Costing Method
Process costing involves tracking the number of units passing through the production processduring a given period, collecting cost information for each stage and then using thecollected information to calculate per-unit cost. Having accurate per-unit-costing helpswith pricing products appropriately, which can lead to improved revenue and better profit margins.
5 Steps in Process Costing
To accurately estimate the cost of producing each unit, process costing takes into accountwork in progress — items that have entered but not completed the production process— at thestart and end of each period. Here are five primary steps in process costing.
Analyze inventory: Analyze the flow of items during the period todetermine the amount of inventory at the beginning of the period, how many itemswere started during the period, how many were completed and transferred out and howmany were incomplete at the end of the period.
Calculate equivalent units: Process costing uses the concept ofequivalent units to account for items that are unfinished at the end of each period.For this step, multiply the number of incomplete units at the end of the period by apercentage representing their progress through the production process. For example,if there are 2,000 units of inventory still in progress and they’re 75%complete,they are equivalent to 1,500 units for process costing purposes (2,000 x .75 =1,500).
Calculate applicable costs: Total the costs for all productionstages, including both direct materials and conversion costs.
Calculate cost per unit: Divide the total cost by the number ofunits. This calculation includes both completed units and equivalent units. So, if abusiness completed 4,000 products and another 1,000 units got halfway throughproduction, the applicable costs would be divided by 4,000 + (1,000/2) = 4,500units. If all the costs added up across all departments to produce those units was$16,875, simply divide the cost by the number of units to arrive at $3.75 per unitproduced.
Allocate costs to complete and incomplete products: Allocate costsfor the completed and ending work-in-progress inventory to the correspondingaccounts. This helps determine how much money is tied up in current work-in-progressinventory. In the above example, since the equivalent of 500 units are in progressand it cost $3.75 to produce each unit, the work-in-progress inventory cost is$1,875 (500 x $3.75). And the complete product inventory cost is 4,000 x $3.75 =$15,000.
Types of Process Costing
In process costing there are three different ways to calculate costs: weighted average,standard costing and first-in first-out (FIFO). Carefully selecting the method that bestmeets your business needs is a best accounting practice.
Weighted average costs: This is the simplest method of calculatingcost. Companies add all costs for the current period and divide by the total numberof units completed and transferred out, plus the equivalent units ofwork-in-progress at the end of the period. It’s used for cases where costfluctuations from period to period are minor.
Standard costs: This method uses an estimated standard cost for eachprocess stage instead of actual costs. Companies typically use this method whenit’stoo difficult or time-consuming to collect current information about the real costs.It can also be beneficial for businesses that make a wide range of items and find itchallenging to attribute precise costs to each of the products. The estimated totalsare compared to actual totals after a production run is finished, and the differenceis added to a variance account.
First in, first out (FIFO): The most complicated process costingapproach, FIFO is used to obtain more precise product costing, especially insituations where costs change significantly from one period to the next. FIFOassumes that the first units in (i.e., work in progress at the beginning of thecurrent period) are the first to be completed. When calculating costs for thecurrent period, it excludes costs incurred during the previous period for thosebeginning work-in-progress units.
Examples of Process Cost Accounting
Process cost accounting is used in circ*mstances where the units of product are hom*ogenous.Take a look at a few examples of how it works in these fictional companies. (The companiesare not real.)
Bubblez’n’More is a seltzer bottling company specializing in uniqueflavors. Thesodas pass through several production departments. During the current month, thefilling department accumulates $25,000 of direct material costs and $50,000 ofconversion costs (consisting of direct labor and factory overhead). For that period,the department processes 50,000 bottles. The per unit cost for the fillingdepartment in April is $.50 for direct materials (direct material costs divided byunit output for the month) and $1.00 for conversion costs (conversion costs dividedby unit output). The company performs similar calculations for the labelling andpackaging departments and finds that overall it spent $100,000 to produce 50,000bottles in one month. The unit price = $100,000/50,000 = $2 per unit.
Reams-a-Plenty makes paper products from wood pulp. Raw materials move through theproduction cycle in a continuous flow, ending with the production of identicalpackages of paper. This month, it completes 150,000 packages. Raw materials total$50,000, or $.33 per package. Conversion costs are $100,000, or $.67 per package,comprising $70,000 in direct labor and $30,000 for overhead, including maintenanceexpenses, insurance costs and electricity. The total cost is $150,000, and with150,000 units produced, its cost-per-unit is $1.
Pros and Cons of Process Costing
For certain types of manufacturers, process costing is the most practical and efficientaccounting method for determining product costs. Still, this method has both advantages anddisadvantages. It can be difficult to accurately assign costs to work in progress, forexample. Consider the following pros and cons.
Pros of process costing:
Process costing can be easier to use than other costing methods, and it canhelp companies zero in on areas for potential cost cutting.
- Ease of use: For companies making many similar goods, process costingis more practical and simpler to use than other cost accounting methods, such as jobcosting, which involves tracking the cost of each item and component part, along withmanaging payroll, other materials and overhead.
- Flexibility: Process costing can help companies improve theiroperations to reduce costs, so they can offer products at more competitive prices. Ithighlights the cost of each step in the manufacturing process, helping companies targetredundant, outdated or inefficient processes.
- Standardized: Process costing applies the same standardized costingmethod each period, enabling companies to compare changes in costs over time. This helpscompanies ensure that costs are in line with budgeted expenses and identify areas forinvestigation.
Cons of process costing:
Potential disadvantages of process costing include inaccuracy.
- Errors: Process costing determines the cost of each unit based on theoverall costs of departments or stages involved in manufacturing. Errors can be causedby including non-production costs in the calculation.
- Calculation difficulties (equivalent units): Process costing alsorelies on calculations of equivalent units, which are determined by assigning costs tounfinished goods at the start or end of an accounting period. Companies include thevalue of this work in process on balance sheets. The real cost of theseunfinished goods can vary, for example if the price of raw materials fluctuates frommonth to month. If companies don’t accurately estimate the cost ofwork-in-progressitems, they’ll end up with inaccurate product costs.
- Time consuming: Calculating equivalent units can be time consuming.Management accountants have to determine how far down the line in the production processthese unfinished goods are and assign costs accordingly.
Cost Flow in Process Costing
With process costing, companies track the flow of costs from department to department, ratherthan tracking costs for each individual item. Each department adds direct labor andmanufacturing overhead costs, plus the cost of any raw materials it uses. Companies may useseparate work-in-process inventory accounts for each department or stage in the process.
Manage Process Costing With NetSuite
Process costing assigns expenses to different departments in your business, and it accountsfor various cost areas including materials and payroll. Those costs are then rolled up todetermine an overall dollar figure and used to find the price-per-unit. All departments mustuse uniform reporting and not double count efforts. Enterprise resource planning (ERP) software can help withthis process. It brings data from various business software modules from around your company— such as supply chain management, financial management and payroll management —into onedigital space. By storing data from disparate areas of your company in one digitalecosystem, you can more easily track data and costs from throughout the manufacturingprocess and keep tabs on expenses and profitability. ERP platforms with integrated financialmanagement software also help you more expertly, easily and accurately perform processcosting. By working together with the same information across the business, costs can easilybe tracked by department and roll up into macro-level process costing reports.
NetSuite’s ERP suite helps manufacturers manage every aspect of their business, fromsupplychain management and procurement to order fulfillment and customer relationship management(CRM). The fully integrated financial managementsolution helps businesses accelerate their financial close, provides strong expensemanagement and real-time visibility into the company’s financial performance. And itcanhelp you more expertly, easily and accurately perform process costing. By working togetherwith the same information across the business, costs can easily be tracked by department androll up into macro-level process costing reports.
Conclusion
Process costing is an important accounting method for manufacturers that make large volumesof identical items, such as companies in the food processing, oil and chemicals industries.For these companies, it can be difficult or impossible to directly allocate costs to eachitem as it moves through the manufacturing process. Process costing enables companies toestimate item costs by adding up the expenses of each step in the manufacturing process,then dividing by the number of items. To ensure accuracy, companies need to include onlyproduct-related costs from each department involved in the process and correctly allocatecost to work-in-progress at each stage. Financial management software, particularlyplatforms integrated into a larger ERP tool, can help track costs by department, as well asgenerate overview reports and store historical data to monitor trends over time.
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Process Costing FAQs
What is an example of process costing?
Using process costing, a seltzer bottling company would assign costs to each stage in thebottling process. It then totals the costs from each stage over an accounting period,dividing the overall process cost by the number of finished bottles to obtain a cost perbottle.
What are the steps in process costing?
There are five basic steps in process costing:
- Determine the number of completed items plus unfinished items produced during eachperiod.
- Translate the work-in-progress items into equivalent units of finished goods bymultiplying the number of unfinished items by their percentage of completion.
- Total the direct materials and conversion costs for each stage in the process.
- Divide the total cost by the number of units to obtain the cost per unit.
- Designate costs for complete and incomplete products.
What are the advantages and disadvantages of processcosting?
For companies that make large volumes of hom*ogeneous products, process costing is muchsimpler than job costing. It also enables companies to hone in on the cost of each stage inthe manufacturing process and look for ways to reduce cost if necessary. But there aredrawbacks, too. Process costing can be time consuming, and it can be difficult to accuratelyassign product costs to each manufacturing stage and to work-in-progress items.
What is a process costing system?
A process costing system is a method typically used within certain sectors of themanufacturing industry to determine the total production cost for each unit of product. Itaccumulates cost from each process or department and allocates them to the individualproducts produced.
Who uses process costing?
Process costing is generally used by manufacturers that produce a large volume of identicalitems, such as companies involved in oil refining, food production, chemical processing,textiles, glass, cement and paint.
How is process costing calculated?
Product costs are allocated to the departments or processes each item passes through over aset period, instead of tracing costs to individual items produced. The total process cost isdivided by the total number of items, resulting in an average cost for each item.
What is construction job costing?
Job costing is an approach to accounting that assigns each expense to a specific job.It’sgenerally broken into three areas: labor, materials and overhead. Construction job costingis a common approach to unique projects with different requirements. Actual costs arecompared against expected budget.
